Two countries, one booming, one struggling: which one followed the free-trade route?

A look at Vietnam and Mexico exposes the myth of market liberalisation

Larry Elliott, economics editor
Monday December 12, 2005
The Guardian

Expect much gnashing of teeth in Hong Kong this week. The chances of securing a comprehensive trade deal are non-existent, with the talks now really about damage limitation and the apportionment of blame.
The development charities will say that the selfish behaviour of the developed world has condemned poor nations to further penury. Washington and Brussels will say the negotiations have been stymied by the obduracy of India and Brazil. Economists will have a field day explaining how the world is turning its back on millions of dollars' worth of extra growth, and that the poor countries will be the ones who will really suffer if the global economy lapses back into a new dark age of protectionism.

That's certainly the accepted view. An alternative argument is that the trade talks are pretty much irrelevant to development and that in as much as they do matter, developing countries may be buying a pup.
The Harvard economist Dani Rodrik is one trade sceptic. Take Mexico and Vietnam, he says. One has a long border with the richest country in the world and has had a free-trade agreement with its neighbour across the Rio Grande. It receives oodles of inward investment and sends its workers across the border in droves. It is fully plugged in to the global economy. The other was the subject of a US trade embargo until 1994 and suffered from trade restrictions for years after that. Unlike Mexico, Vietnam is not even a member of the WTO.

So which of the two has the better recent economic record? The question should be a no-brainer if all the free-trade theories are right - Mexico should be streets ahead of Vietnam. In fact, the opposite is true. Since Mexico signed the Nafta (North American Free Trade Agreement) deal with the US and Canada in 1992, its annual per capita growth rate has barely been above 1%. Vietnam has grown by around 5% a year for the past two decades. Poverty in Vietnam has come down dramatically: real wages in Mexico have fallen.

Rodrik doesn't buy the argument that the key to rapid development for poor countries is their willingness to liberalise trade. Nor, for that matter, does he think boosting aid makes much difference either. Looking around the world, he looks in vain for the success stories of three decades of neo-liberal orthodoxy: nations that have really made it after taking the advice - willingly or not - of the IMF and the World Bank.

Rather, the countries that have achieved rapid economic take-off in the past 50 years have done so as a result of policies tailored to their own domestic needs. Vietnam shows that what you do at home is far more important than access to foreign markets. There is little evidence that trade barriers are an impediment to growth for those countries following the right domestic policies.

Those policies have often been the diametric opposite of the orthodoxy. South Korea and Taiwan focused their economies on exports, but combined that outward orientation with high levels of tariffs and other forms of protection, state ownership, domestic-content requirements for industry, directed credit and limits to capital flows.

Rodrik says: "Since the late 1970s, China also followed a highly unorthodox two-track strategy, violating practically every rule in the guidebook. Conversely, countries that adhered more strictly to the orthodox structural reform agenda - most notably Latin America - have fared less well. Since the mid-1980s, virtually all Latin American countries opened up their economies, privatised their public enterprises, allowed unrestricted access for foreign capital and deregulated their economies. Yet they have grown at a fraction of the pace of the heterodox reformers, while also being buffeted more strongly by macroeconomic instability."

This is an argument taken up by Ha Joon Chang in a recent paper for the South Centre, the developing countries' intergovernmental forum. Chang argues that "there is a respectable historical case for tariff protection for industries that are not yet profitable, especially in developing countries. By contrast, free trade works well only in the fantasy theoretical world of perfect competition."

Going right back to the mid-18th century, Chang says Pitt the Elder's view was that the American colonists were not to be allowed to manufacture so much as a horseshoe nail. Adam Smith agreed. It would be better all round if the Americans concentrated on agricultural goods and left manufacturing to Britain.

Alexander Hamilton, the first US Treasury secretary, dissented from this view. In a package presented to Congress in 1791, he proposed measures to protect America's infant industries. America went with Hamilton rather than Smith. For the next century and a half, the US economy grew behind high tariff walls, with an industrial tariff that tended to be above 40% and rarely slipped below 25%. This level of support is far higher than the US is prepared to tolerate in the trade negotiations now under way.

The lesson is clear, Chang says. South Korea would still be exporting wigs made from human hair if it had liberalised its trade in line with current thinking. Those countries that did liberalise prematurely under international pressure - Senegal, for example - saw their manufacturing firms wiped out by foreign competition.

Infant industry

He draws the comparison with bringing up children. "In the same way that we protect our children until they grow up and are able to compete with adults in the labour market, developing country governments need to protect their newly emerging industries until they go through a period of learning and become able to compete with the producers from more advanced countries."

As with children, infant industry protection can go wrong. But, says Chang, "just as failures in the world of parental protection are hardly an argument against parenting itself, so cases of failures of infant industry protection do not constitute an argument against infant industry protection per se - especially when history shows that with startlingly few exceptions, successful countries in the past and in the present have used infant industry protection".

The chances of success are increased if the choice of target infant industries is realistic, protection is combined with an export strategy, the state imposes discipline on the firms receiving protection and the government is competent.

Another counter-argument is that while a modicum of protection may be necessary, most developing countries now have tariff rates much higher than those used by today's developed countries in the past. Chang says this ignores one vital point: the productivity gap between rich and poor countries today is far higher than it was in the past, so it is perfectly logical for tariffs to be higher.

For example, Britain and the Netherlands were perhaps up to four times as rich as Japan or Finland in the 19th century; today, Switzerland or the US is 50 or 60 times as rich as Ethiopia or Tanzania. Yet in Hong Kong the pressure will be on the bigger developing countries to make the big concessions on industrial tariffs, cutting them to levels below those that existed in most rich countries until the early 1970s.

History suggest that accepting the demands of Washington and Brussels would be unwise, to say the least.